The Case for Increased Regulation

I read a very interesting article in the New York Times the other day (it's now archived so you have to subscribe to see a copy of the article, entitled When Regulators Knock Twice. The article explained how an old adversary of mine, an insurance company named Fremont Casualty, was run into the ground by management using (according to the NYT at any rate) a sneaky little scheme involving reinsurance for their Workers' Compensation insurance operations.

Once upon a time, Fremont was a significant player in the Workers' Compensation insurance business. They were one of the major writers of California Workers' Compensation insurance back in the 1990's. I personally got the pleasure of dealing with Fremont when they purchased the largest single writer of Illinois Workers' Compensation insurance back in the 1990's. I found their audit people to be difficult to work with, but still managed to recover overcharges that had occurred.

But Fremont spectacularly flamed out of business a few years ago, shut down by insurance regulators. And according to the NYT article, the reason for the flame out was that executives of Fremont had decided to juice up their own bonuses and earnings by rigging a clever little reinsurance maneuver. They dramatically lowered the threshold where reinsurance would take over payment of Workers' Comp claims, and then dramatically changed their underwriting standards so that they would underwrite risky lines of business at discounts. This resulted in great increases in premiums, and the reinsurers were the ones responsible for paying most of the increased claims costs that resulted. It worked fine for a while, until the reinsurers figured out the game and balked.

Fremont itself was then left with the disastrous claims results of their new underwriting standards, and it didn't take long for those costs to destroy the company.

Most interestingly, those executives and managers have, according to the Times, repeated their clever scheme in a new arena--sub-prime lending. that's because although Fremont insurance went under, Fremont General (the parent company) remained open for business in other fields. But in March the F.D.I.C. issued a cease-and-desist order to Fremont which charged that Fremont had “engaged in unsafe or unsound banking practices and had committed violations of law and/or regulations.”

Deja vu all over again.

All of which leads me to ponder how the lack of regulation of both the insurance industry and the lending industry may have allowed companies like Fremont to pursue such ill-advised schemes, while leaving the greater society holding the bag. After all, California famously "deregulated" their Workers' Compensation insurance market back in the mid-1990's, setting the stage for Fremont and some other significant California Workers' comp insurers to pursue strategies that ultimately imploded their companies and created huge disruptions for California employers who still needed to get Workers' Compensation insurance coverage.

Our currently-unfolding debacle involving sub-prime lending appears to be another instance when lack of effective regulation has allowed exeuctives and managers to pursue business strategies that generated considerable benefit in the short term to those same executives and managers, while ultimately creating huge disruptions in vital financial markets.

The neocon view that regulation stifles innovation in financial markets would appear to be, at least in my view, fairly well discredited by the double disasters created by Fremont and their fellow travellers. Once upon a time, insurance regulators understood that rate adequacy and market stability were factors that needed to be kept in mind, lest essential markets be disrupted. But the trend in recent decades has been to diminish or even eliminate most regulation of commercial insurance and other financial industries. In the short term, there were benefits to both consumers and to the industries. But in the longer term deregulation has simply ended up making the case for the need for some level of effective regulation of insurance and financial markets. Just ask employers out in California who have been dealing with the fallout of the disasterous deregulation of Workers' Compensation insurance. Or just watch our current financial markets deteriorate as the full impact of the largely unregulated lending business devastates hedge funds, insurers, and other financial institutions. The long term costs of deregulation can be huge and hugely disruptive, while the only real "innovations" are in the form of "creative" underwriting, accounting, marketing, and, of course, executive compensation.

This may be a lesson we're all about to re-learn at great cost.